The Bank of Canada continued to ultra-fine-tune monetary policy this week with a quarter point drop in interest rates. A little tweak here, a little tweak there — this seems to be the preferred policy over the past couple of years.
And yet, one wonders whether a more principled stance would reap greater economic rewards, say in the form of more stable investor confidence and higher income growth.
Twisting the dials on monetary policy can certainly have positive effects, as we saw in mid-2003 as the Bank rushed to head off developing sogginess in the economy.
But there is also the potential for mistakes in activism, like the spring rise in interest rates last year that contributed to that very same economic weakness. Maybe a stay-the-course approach, relying much more on market pricing to generate monetary conditions, would produce more consistently positive results.
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In any case, we must live with the world as it is, and the bank's move to ease monetary policy did have the laudable attribute that it followed, rather than provoked, money market pricing. Street traders had already taken the froth off the surging Canadian dollar and dropped interest rates in anticipation of the bank move, even with a split view from economists on the likely course of the rate decision.
As for the bank's rationale, the case is rather solid for easing monetary policy. Inflation is below the 2 per cent target mid-point, a traditional marker for easier policy. There is greater-then-expected slack in the economy. And the prior one-fifth rise in the currency through last year can only moderate economic growth this year. The bank made the additional point that these conditions, low inflation and moderating growth, will likely persist into 2005.
That last sentence is unfortunately where the train can become derailed. No one, including the bank's impressive coterie of forecasters, really knows where the economy will head over the next 24 months. Add to that the complication of assessing the likely course of the U.S. economy, possible inflation shocks, Fed monetary policy, the bond market, and the currency. We can all speculate -- but we truly cannot know the intermediate future to any great degree of precision.
How about foregoing all of that effort and placing more faith with financial markets? A rule-of-thumb that kept short-term interest rates in line with the real opportunity cost of capital (say, pegged to real return bond rates) would provide greater certainty to market participants. Bond yields, stock prices and currencies could then be priced off a stable and more predictable monetary environment.
The benefit would not be immediate, and could occasionally clash with U.S. policy, but over time there would be a greater role for the markets and the economy to self-adjust. The temptation to use available policy tools is always great — but sometimes the road to virtue lies in quietly standing aside.
Mark Mullins is an economic consultant and financial markets analyst. He is also Director of Ontario Policy Studies at the Fraser Institute. Any views expressed here are strictly his own and not necessarily those of the Fraser Institute.